The Christmas Tree Effect

Well, the gong has struck, now that a closely divided House of Representatives has failed to approve round one of the bailout program. The stock market responded with a deep plunge, as the uncertainty continues. It is too early, however, to write a definitive post-mortem because some new proposal may make it through a suspicious and hostile Congress. But it is instructive to understand at least some of the reasons why this initial effort fell apart.

Let's start with the distant and balmy past--March 2008. The Federal Reserve and the Treasury were able to work out, over a single weekend, a bailout arrangement for Bear Stearns, whose most desirable feature was to give the former equity holders of the firm only a tiny stake in the new financial entitles. Two key conditions made that bailout agreement possible. First, the illusion that fixing Bear Stearns offered a once-and-for-all solution to the financial unrest. Second, the stakes were low enough not to tax unduly the public fisc.

The proposed $700 billion bailout, not surprisingly, did not escape notice in Congress and the White House. Now new players elbowed a place at the table. In complex negotiations more is not merrier. It only gives more people a blocking position over the deal. That slowdown allows outside experts acting on incomplete information to propose new solutions, which reduced the odds of a quick settlement.

The addition of political types also generated another risk, which can be dubbed the Christmas tree effect. Fannie and Freddie may need some baubles on the tree, and perhaps
AIG
needs another. But nothing about the design of bailout limits the permissible scope of political negotiation. So now the Democrats in Congress can flex their populist muscle to expand the agenda.

Alas, new ideas are likely to be bad ideas. Here are two nonstarters that were live options in the first go-round. First, limit executive compensation. Not smart. Envy is a bad emotion. Of course, everyone should be astounded that the pay of CEOs can go through the roof, even though at Fannie and Freddie they should have gone through the floor.

Still it would not be a bright idea for the bailout plan to heap extra taxes on executive pay in excess of the salary of the president of the United States, unless you throw in some state dinners, fancy digs and a private 747 as business perks. After all, private equity companies always pay their key inside officials more than public corporations do theirs. If we want people to put their reputations under the guillotine, then we have to compensate them before their broken careers are carted off in tumbrels to some management graveyard. We need able people, not low salaries.

Equally unwise would be any effort to tie an eventual bailout to additional homeowner relief from foreclosure market, here in the form of requiring "reasonable" adjustments in mortgage terms. Any financial bailout, wise or foolish, will work less well if the housing stock remains tied up in ways that make securitized mortgages even more difficult to value.

Case-by-case alteration of terms, without guidelines, would be the worst way to go. Mass markets need rigid standardization. The real losses from the housing bubble are sunk costs that won't disappear--period. And, unfortunately, they have seeped so far into every financial cranny that no bailout can spread them much further. Here is another decoration that should be kept off any new Christmas tree.

Going forward, two clouds could still blot out much of the silver lining of any purported bailout.

First, valuing the securities that the government takes into its portfolio, if it takes them at all, is no picnic. Some premium over the wretched "mark to market" standard seems appropriate, but how to calculate it is not a self-evident truth. So here is some discreet advice for the next round: Better to truncate the size of a second generation bailout plan by relaxing that rule for private holdings.

Second, the first bailout plan did not reach any consensus on how to fund any bailout. Work was for the next Congress and president. But face that issue head on. A crisis deferred is a crisis magnified, by a permanent expansion in government power. There are real costs to having too many players at the tea party. Shrink the bailout first, says the weary libertarian.

Richard Epstein writes a weekly column for Forbes.com. He is a senior fellow at Stanford's Hoover Institution and a professor of law at the University of Chicago.